If only leaders would follow the rules

Government at its simplest is about taxing and spending. Over time these should balance out. When things are booming we’re taxing more and spending less. In lean years it’s spending to the fore. What could possibly go wrong?

Plenty, it seems. We’ve been running deficits in good years and bad. Cumulatively that’s seen public debt balloon to the point where it’s become unsustainable.

We’ve got tax revenue increasingly being used to service past excesses. This means there’s never enough left to cover the needs of government today without borrowing more.

That’s the challenge facing both Europe and the US; too much debt, not enough income.

Somebody asked me the other day how this could happen. If it’s that obvious, they asked, why weren’t there rules designed to stop this happening in the first place?

The simple answer is, there are. Sensible rules that if appropriately applied were capable of avoiding just the mess governments find themselves in today.

The European Union adopted its original Stability and Growth Pact 15 years ago. This was meant to enforce an annual budget deficit limit of 3 per cent and a national debt threshold of 60 per cent of gross domestic product (GDP).

If they’d applied these simple parameters we wouldn’t be talking about a sovereign debt crisis today.

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But they were largely ignored from day one. Even the fiscally conservative Germans quickly fell foul of these limits. They were seen as too inflexible, as they took no account of the economic cycle. So they were soon being bent or ignored.

In the US we’ve got political deadlock, as Republicans and Democrats approach the challenge of sustainable deficit and debt reduction from diametrically opposing positions.

This has seen Washington gripped by a debilitating policy freeze that threatens to push the US economy back into recession. We’re now just five months and counting from a fiscal train wreck that risks stripping $US600 billion from the US gross domestic product.

Now we’ve got the backlash, with fiscal austerity being foisted on the economic underperformers in some form of twisted logic that assumes governments doing less will somehow reverse an already accelerating recessionary slide. This short-term papering over past mistakes isn’t what’s needed.

In fairness, European policymakers have done a reasonable job designing a framework that should work in the longer term.

Where they’ve failed is working out how they extract themselves from the current mess sufficiently to be able to adopt this fiscal logic.

In March the European Council finally agreed on a new intergovernmental treaty, the Fiscal Compact. While this was an EU initiative, it’s primarily an agreement to facilitate fiscal as well as monetary union for the euro zone.

It’s been built around the “six pack" of EU regulations and directives that are due to take effect in early 2014.

This introduces a new national structural budget balance rule that will limit annual structural deficits to a maximum of 0.5 per cent of GDP.

It mandates stronger enforcement of national rules, which required legislated automatic correction mechanisms.

It creates a new supranational debt rule that includes commitments to “continuously reduce the public debt to GDP ratio back to 60 per cent". There’s a new supranational expenditure benchmark added, which limits annual growth in primary expenditure to the long-term nominal GDP rate.

It adds broader criteria and a more automatic process to deal with non-compliance, by requiring offenders to be placed under a formal excessive deficit procedure.

And lastly, it provides the basis for a more binding medium-term budget framework, which will need to work far more closely with national independent fiscal councils.

The fiscal compact has got the makings of a workable structure because it relies on a variety of fiscal rules.

A new report by a group of International Monetary Fund economists, led by Andrea Schaechter, defines a fiscal rule as an edict that imposes a long-lasting constraint on fiscal policy through numerical limits on budgetary aggregates.

Ideally this should aim at “correcting distorted incentives and containing pressures to overspend, in particular in good times, so as to ensure fiscal responsibility and debt sustainability".

It’s been a failure to contain this pressure to overspend that’s been where most governments have fallen down over recent years.

The IMF report, Fiscal Rules in Response to the Crisis, looks at what’s worked, and what hasn’t, over recent years and touches on a range of more complex “next generation" tenets that are now being adopted by governments. These combine the objectives of sustainability with the need for flexibility in response to shocks.

So what do we mean when we talk about fiscal rules? In essence there are four types – those that influence debt, revenue, expenditure or budget balance.

Debt rules set an explicit limit or target for public debt in percent of GDP, while budget balance rules constrain the variable that primarily influences the debt ratio and are largely under the control of policymakers.

Expenditure rules set limits on total, primary, or current spending, while revenue rules set ceilings or floors on revenues and are aimed at boosting revenue collection and/or preventing an excessive tax burden.

Twenty years ago you’d have been hard pressed to find a government that thought formal fiscal rules were necessary. In 1990 you could count them on one hand. The list included Germany, the US and Japan as well as Luxembourg and, somewhat surprisingly, Indonesia. Today there are over 75, including Australia, thanks to the Howard government’s Charter of Budget Honesty.

The IMF report describes three waves of policymaking. The first, in the mid-1990s, was in response to the bank credit crisis and the advent of the euro zone.

The second arrived in the early 2000s and was largely driven by emerging market economies in response to the Asian credit crisis.

The last arrived in the wake of the global financial crisis, as rules were added in response to the stresses placed on the public purse by a combination of aggressive fiscal stimulus and hefty bank recapitalisation requirements.

Hopefully this last wave might do the trick – given how far the first two came up short.